Cash flow planning is key to a good financial plan

Many of my readers keep asking me as to why I do not have different portfolios allocated to different goals of mine. I have explained this in other posts so will not repeat the basic arguments here. Suffice it to say, multiple portfolios will most likely lead to sub-optimal returns and I do not look upon it as smart financial planning at all. In fact if you really look at how you go about your life and the finances you need ta take care of your plans, the most important aspect is really cash flows.

While cash flows are kind of implicit in goal based planning – we are asked to redeem our financial investments to cater for the expenses linked to a goal – it is important to understand the true nature of it. In a recent discussion with a friend it struck me that most people do not have a clear idea about it at all and do not understand how to go about it. When I was thinking of how to explain this to my readers, I thought of how we use water in our daily lives. This is an analogy I have used in one of my earlier posts and can be used well here.

Let us assume a normal middle class household in India where we have different types of expenses such as listed below:-

  • Regular monthly expenses such as food, groceries, utility bills, transportation etc.
  • Quarterly or biannual expenses such as school or college fees.
  • Annual expenses such as Insurance premiums, TV subscription etc.
  • Irregular expenses such as clothing, purchases of personal discretion.
  • Large expenses such as White goods, Vacations abroad etc
  • Goals such as College admission, marriages etc.

To personalise this example let me relate it to you as a reader. For the next 12 months, list out all possible cash needs you have out of these categories. For example you may have something looking like this:-

  • Monthly household expenses @ 40000, Annual costs = 4.8 lacs
  • School fees @ 10000, Annual costs = 1.2 lacs
  • Insurance premiums, TV service etc, Annual costs = 1 lac
  • Vacations, White goods, Annual costs = 1 lac
  • No large goals in next 12 months.

What does this really mean? In cash flow terms, your outflow will be to the tune of 8 lacs. So if you have got 8 lacs and more from your salary or business you are fine, right? This is unfortunately not true at all – understand that your outflows on large goals are not there now but they will occur at some point in time. When it does you have to spend and that amount may not be possible from your normal cash inflow. Let us say your son will go to a college that costs 5 lacs a year for 4 years. If this amount can be catered for through your active income, you are home and dry. If not then you must invest in the years before he gets to college so that when the time comes you have access to the money. Similarly you need to plan for your retirement – at that time you have no active income but your household expenses remain there. So, you must have some alternate source of cash inflow so that you are able to sustain your expenses.

Where does cash inflow come from? Well, there can be several sources, but some of the more common ones are as follows:-

  • Salary from your job
  • Income from business or profession
  • Income from hobbies or other interests ( blogging etc)
  • Interest income, dividends
  • Rental income
  • Capital gains from selling an asset
  • Redeeming financial instruments

Where does the water analogy come in? Well, you can think of regular cash flows as the water that is supplied to your house every day by the City corporation. Most of your needs are met by that. However, you also store some water for an emergency that may occur. In case you are planning to clean your house thoroughly, you will plan to arrange for availability of water etc. What happens if you are having a big function at your house and you need to have a lot of water? Well, in case you have stored it in a tank etc you can use that. Alternately you can get some water tankers to get water for you. This is similar to redeeming financial instruments for a large goal. You can also stretch the thought process to look at these tankers as a loan – in that case you have to pay back the water just as you pay back through EMI for the loans.

The bottom line is this – your cash inflows either in term of current income or income from past investments or loans must match your cash outflow needs at all points in time. With the water analogy we have to look at running water, water stored earlier or water obtained from external sources such as tankers to take care of our needed consumption.

Pretty simple really, if you think of it a little and then the entire financial planning just becomes an exercise in cash flow management. How do we factor in investments into this? Well, I will cover that in another post as this one has already got quite long.

Funding my daughter’s marriage

Now that my daughter Rinki is going to be 23 soon, it is time to start thinking that she will get married in a few years. Of course, given the fact that she is in the second year of her BM program at XLRI and will probably work a few years before getting married, I think we are still looking at another 4 years or so, maybe 5. However, given the kind of expenses it entails one must plan for it in advance.

As my regular readers will know well I do not have separate portfolios assigned to specific financial goals. I simply have 3 portfolios of Debt, Stocks and MF where I invest in and take out money from these as and when needed. So far this has really not been needed as I have always had enough to spend from my active income. This is true even in my current state of Financial independence but may not remain so at the point of time my daughter gets married. There is thus a need to plan for this.

In general, my idea always had been that I will pay for my children’s graduation, no matter how much it cost, and also a reasonable amount in their marriage. Post graduation was something I wanted my children to fund themselves, normally through a bank loan or even taking some money as a loan from me. I did not see much point in paying high interest rates to the banks. This will burden the child with high EMI and restrict his or her freedom to make the right choices.

Based on all of these, when Rinki got admitted to XLRI we took a 12 lacs loan even though the course fees were in the range of 22 lacs. The idea was that I will pay much of the first year fees and she would get it paid by the bank in the second year. Total costs for the first year was 10.5 lacs and we took only 50000 from the bank. This was needed to keep the loan valid. In the second year the fees to be paid are as follows – 4.71 lacs in June, 2.5 lacs in August and 2.5 lacs in November. Right now we have paid the first 4.71 lacs through our own resources – Rinki had some internship money from her Summer stint in GE, one of the FMP I had earlier done for her reached maturity and a FD I had done some years back matured now. Under ordinary circumstances I may have needed the money for my expenses but as my active income is going well in 2017 the flexibility is quite a lot more.

With the above backdrop and the assumption that Rinki is likely to get a job which will pay her at least the median salary in XLRI, I have worked out the following plan with her

  • We will try to restrict the bank loan to 4.5 lacs or so.
  • In the first year of her job, she will pay back the loan in full. Along with the interest this may come to 40000 per month.
  • Assuming that she gets a take home salary of 1.2 lacs per month and needs to spend about 40000 on regular expenses, she will still have 40000 left as surplus in year 1.
  • From year 2 the surplus is obviously a lot more.

What about the money I have paid for her PG education? It will amount to about 14 lacs and I do not want her to pay it back to me. I have asked her to invest it in a portfolio of 4-5 MF over the next 3 years @ 40000 per month. Over this period the amount of the corpus will be 17.4 lacs and in 4 years it will be about 20 lacs. This is the amount I plan to utilise for her marriage. Yes, the costs may be more and if so, I will fund the gap.

What if she decides not to get married at all or get married later. Well, in the first case the money is her’s to use in any manner she wants to. In the second case, the money will remain invested and we will be using it as and when she gets married.

For my son the issues will be simpler as the marriage expenses are likely to be lower. Also, like I did for myself, I am hoping he will be able to foot the bill to some extent, if not for all of it like I did. That is way down the future though, at least 8 years if not more.

Saving for your own marriage or education? Here’s how

Our social norms and practices have undergone huge changes in the past decade or so and this is a continuous process. One area where this is seen quite starkly is how marriages are arranged and carried out today. In the older days the parents were most likely to find a match for their child, arrange the marriage logistics and of course pay for the same. Given the fact that people married relatively young, especially the women, it made sense to do this then.

Times have changed greatly now, especially in urban India. The incomes have increased manifold but so have the responsibilities of parents. Increased cost of school education, high graduation costs and not really being able to depend on children for the retired years like before has created a need for funding retirement to a much greater extent than ever before. Also, as children nowadays prefer to choose their own partners and have their own ideas about how the marriage should take place. In this kind of situation it makes a lot of sense for the children to plan for their own marriage expenses. Of course the parents will give gifts etc as per their financial bandwidth but in case there is a seriously expensive wedding, that needs to be planned by the child.

So, let us say you are just out of college and are in a job which pays you about 50000 Rs a month. How do you go about planning your life at 22, when many things are not really firmed up for the near term or far term? For example, you may want to do an MBA, may have ideas to start something on your own in a few years time or may have an idea of getting married in 6-8 years time. While you do not have to decide exactly on what course of action you want to follow, it will be important for you to invest from the beginning in a fairly disciplined manner. This will enable you to have the financial ability to do the spend when required.

How do you start? We will assume that your initial salary is 50000 a month and this will increase at 10 % every year. You should be doing the following:-

  • You really do not need insurance so do not spend on it. For debt investments your PF is adequate but as a matter of good habit open a PPF account and put 5000 every month in it.
  • With the above and your monthly expenditure you should still be able to invest 10000 per month in MF fairly easily. In case you can do more, all the better.
  • With every passing year increase this amount by 5000 Rs per month. This should not be difficult with your annual increments or job changes, if any.
  • Assuming you plan to work for 5 years before you need the money and it grows at 12 % every year how does it look?
    • Initial 10000 for 5 years will grow to 8.24 lacs
    • Next 5000 for 4 years will grow to 3.09 lacs
    • Next 5000 for 3 years will grow to 2.17 lacs
    • Next 5000 for 2 years will grow to 1.36 lacs
    • Final 5000 for 1 year will grow to 0.64 lacs
  • So in 5 years you will have a corpus of 15.5 lacs.
  • You will also have about 5 lacs in your PPF account

With this in place you can easily plan for your marriage or higher education. For example if you want to do an MBA from ISB the cost is about 30 lacs today. You can use part of your corpus and also take an Education loan. In case you are looking at funding your marriage, the amount in your corpus should be adequate for most weddings.

Now many financial planners will tell you that you must not put money in equity for 5 years etc. Do not listen to them at all. Firstly you are creating an MF portfolio which you may or may not want to redeem in 5 years time. So, strictly speaking there is no real need to think of it as 5 years. If you do not need the money, you just continue with the portfolio as normal. Just to motivate you a little more, if you keep investing 10000 for 25 years, at a return of 12 %, you will end up with 1.9 crores from just here.

I hope this has given all the new earners a lot of food for thought. You need to be in charge of your finances now. So far your life events have been largely managed and almost wholly funded by your parents. Now is the time to really chart out your own course and depend on your own resources for the same.

Once you make up your mind to do this, success is almost guaranteed.

A life plan must precede a financial plan

With the increasing readership of my blog, I get a lot of requests to either make financial plans for people or to review an existing financial plan that was made by someone for them. What strikes me as amazing is that people by and large focus greatly on their financial goals and almost take their life goals for granted. This flies in the face of the obvious reality – your finances are there to support your life goals and therefore must come after you have thought through your life goals.

The first thing which surprises me is that people project their lives for the next 30 years or so without having the ambition to do more with it. Let us say you have passed out of college and got a job. While it may be a job which you like, you may still look at ways and means of improving it. An IT person who started his career just 5 years back may already be finding himself in the cross roads. There is no guarantee that your current job will last for 10 years, let alone 30. It is therefore imperative that you fix your life goals based on your current skills, future skills you may need to acquire and the kind of work you want to do. It may be necessary for you to take up your first job for many reasons, but there will be equally good reasons as to why you may want to do other things.

The same goes for people who are in their mid career with a family. Yes, changing your life direction may be more difficult now but it is not impossible by any means. I had a friend who was a hotel manager for 10 years, worked in Rediff for another 10 years, went on to do an MBA abroad and is now a professor in an US Business school. Note that the latter career moves were all done when he had a family. Another friend of mine who is from an IIT and an IIM, went to the US recently to pursue a second MBA as he was not happy with how his career was shaping up. In his case too he took his wife and a young daughter to the US. There is no doubt that these people had to go through a lot of tough times but they were clear as to what they wanted to achieve.

Changing careers are getting much more common nowadays than ever before. I just came to know of a Doctor, who practised for 7 years after his MBBS and has now got into IIM Ahmedabad for their one year Executive program. He wants to be associated with Health care but not as a practising Doctor and felt that an Executive MBA will give him the opportunities that he is seeking out.

The problem with financial plans is that they are done assuming people will proceed in their lives linearly. They will start with a job, increase their salaries every year, get married, invest and increase their investments, plan their finances, home buying and have other goals such as children’s education, marriage and retirement. This does not at all cater to real life and real people. For example, I started working at 24 and always wanted to retire at 45, or at least be financially independent by then. If I had been to a financial planner, he would probably have told me that I needed to work for 35 years and early retirement was just not possible in India.

The logic can get extended to any particular passion you have in life. Earlier it was difficult to take up your passion due to lack of resources and opportunity. However, many people nowadays want to take up their passion after they have fulfilled most of their responsibilities. I know of people who have taken up travel, reading, teaching and several other interest areas at a relatively late stage in life and have done very well in them.

So the point is your life plan must be dynamic in nature to fulfil the aspirations you have. We will not meet all our aspirations but there should be a clear and concerted attempt to do so. The financial plan must adapt to your life journey not the other way round. You need a financial planner who understands this.

How does one go about doing this? Let that be the subject of another post.